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Credit Spreads and Business Cycle Fluctuations

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  • Simon Gilchrist
  • Egon Zakrajšek

Abstract

This paper examines the evidence on the relationship between credit spreads and economic activity. Using an extensive data set of prices of outstanding corporate bonds trading in the secondary market, we construct a credit spread index that is—compared with the standard default-risk indicators—a considerably more powerful predictor of economic activity. Using an empirical framework, we decompose our index into a predictable component that captures the available firm-specific information on expected defaults and a residual component—the excess bond premium. Our results indicate that the predictive content of credit spreads is due primarily to movements in the excess bond premium. Innovations in the excess bond premium that are orthogonal to the current state of the economy are shown to lead to significant declines in economic activity and equity prices. We also show that during the 2007–09 financial crisis, a deterioration in the creditworthiness of broker-dealers—key financial intermediaries in the corporate cash market—led to an increase in the excess bond premium. These find- ings support the notion that a rise in the excess bond premium represents a reduction in the effective risk-bearing capacity of the financial sector and, as a result, a contraction in the supply of credit with significant adverse consequences for the macroeconomy.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17021.

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Date of creation: May 2011
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Publication status: published as Simon Gilchrist & Egon Zakrajsek, 2012. "Credit Spreads and Business Cycle Fluctuations," American Economic Review, American Economic Association, vol. 102(4), pages 1692-1720, June.
Handle: RePEc:nbr:nberwo:17021

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  1. Arturo Estrella & Gikas A. Hardouvelis, 1989. "The term structure as a predictor of real economic activity," Research Paper 8907, Federal Reserve Bank of New York.
  2. Fama, Eugene F, 1981. "Stock Returns, Real Activity, Inflation, and Money," American Economic Review, American Economic Association, vol. 71(4), pages 545-65, September.
  3. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
  4. Sreedhar T. Bharath & Tyler Shumway, 2008. "Forecasting Default with the Merton Distance to Default Model," Review of Financial Studies, Society for Financial Studies, vol. 21(3), pages 1339-1369, May.
  5. Hodrick, Robert J, 1992. "Dividend Yields and Expected Stock Returns: Alternative Procedures for Inference and Measurement," Review of Financial Studies, Society for Financial Studies, vol. 5(3), pages 357-86.
  6. Gary B. Gorton, 2009. "Information, Liquidity, and the (Ongoing) Panic of 2007," NBER Working Papers 14649, National Bureau of Economic Research, Inc.
  7. Thomas Philippon, 2006. "The Bond Market's q," NBER Working Papers 12462, National Bureau of Economic Research, Inc.
  8. Vladimir Yankov & Egon Zakrajsek & Simon Gilchrist, 2009. "Credit Market Shocks and Economic Fluctuations: Evidence from Corporate Bond and Stock Markets," 2009 Meeting Papers 514, Society for Economic Dynamics.
  9. Houweling, P. & Mentink, A.A. & Vorst, A.C.F., 2003. "Comparing possible proxies of corporate bond liquidity," Econometric Institute Research Papers EI 2003-49, Erasmus University Rotterdam, Erasmus School of Economics (ESE), Econometric Institute.
  10. Jon Faust & Simon Gilchrist & Jonathan H. Wright & Egon Zakrajsek, 2011. "Credit Spreads as Predictors of Real-Time Economic Activity: A Bayesian Model-Averaging Approach," NBER Working Papers 16725, National Bureau of Economic Research, Inc.
  11. James H. Stock & Mark W. Watson, 2001. "Forecasting Output and Inflation: The Role of Asset Prices," NBER Working Papers 8180, National Bureau of Economic Research, Inc.
  12. Schaefer, Stephen M. & Strebulaev, Ilya A., 2008. "Structural models of credit risk are useful: Evidence from hedge ratios on corporate bonds," Journal of Financial Economics, Elsevier, vol. 90(1), pages 1-19, October.
  13. Harvey, Campbell R., 1988. "The real term structure and consumption growth," Journal of Financial Economics, Elsevier, vol. 22(2), pages 305-333, December.
  14. Gregory R. Duffee, 1998. "The Relation Between Treasury Yields and Corporate Bond Yield Spreads," Journal of Finance, American Finance Association, vol. 53(6), pages 2225-2241, December.
  15. Maria Vassalou & Yuhang Xing, 2004. "Default Risk in Equity Returns," Journal of Finance, American Finance Association, vol. 59(2), pages 831-868, 04.
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  1. > Econometrics > Forecasting > Forecasting Economic Activity Using Financial Variables
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